Clear Indexes Ideas

Leverage and Hedging

Is our headline about weapons of mass destruction or tools to increase alpha while reducing beta? Leverage and Hedging are two distinctly different techniques that can be used independently but, we believe, belong together. True this post could have been titled: Juicing Returns Balanced with Proper Risk Management, but it is not. As a disclaimer, Clear Asset Management cannot use either of these techniques by mandate.

Testing these tools reminds me of the first time I pressed the accelerator of a car. My brave big brother, who took me to the local school parking lot for my first foray, told me many times about the power one feels when jerking several thousand pounds of steel forward. He instructed me to use the power in a calculated way. It could take me where I want to go faster than my feet or bicycle, and there are times to accelerate more and times to ride the break. This was an early lesson in the use of leverage and hedging. Unlike in financial markets, a car for a new driver cannot be back tested, nor can it be paper traded before deploying live money.

The volatility in the market has caused us, along with many other managers, to take a beating. This has occurred during this and other downturns. Volatility is inescapable in any investment, but especially for long-only managers, including us. I have posted about our risk management and we have been turning our portfolios over based on protecting gains and stopping losses as our risk and trading rules mandate, and will weather this storm as we have so many previous ones.

Our tools are not the exact same as some employed by hedge funds because we are long-only, meaning we can not sell short a stock with the intention of profiting when it goes down. As a long-only manager, we cannot hedge. Balancing long and short positions is known as hedging, hence the name.

The issue right now seems to be that too many hedge funds are not currently hedged. Yesterday Bloomberg.com reported that the Raptor Fund managed by industry legend Tudor Investment Corp. lost 9% in July. Sowood Management LP, led by a former Harvard Management executive, said July 30 that it lost $1.5 billion and Caxton Global Investments, an $11 billion fund, held on to a mere 3.5% gain for the year through July, which lags three out of four of our flagship portfolios.

Many of the losses at these hedge funds, along with two funds at Bear Stearns that cost the head of its asset management division his job, were due to the use of leverage. Leverage is essentially the scaling up of a purchase. Two to one, five to one, ten to one or twenty to one leverage has been in place at some funds. An example of how this can backfire is to use $1 million with 10x leverage, putting $10 million to work in the market. If the leveraged securities go down 5% you just lost $500,000 or 50% of your initial capital. Now imagine this technique being applied to billions of dollars. To prevent these types of losses, the better firms hedge their long positions with short positions so catastrophe cannot strike. It appears some funds have lost their discipline, with respect to hedging, leverage, or perhaps both.

The losses by these large funds add to the market volatility that, the consensus of the media and Wall Street chiefs agree, has been caused by credit markets tightening due to subprime mortgages in default. Their losses add to the uncertainty, adding to the volatility of the market.

Ultimately the long-term returns of the majority of hedge funds usually under perform top quartile performing long-only managers such as Clear Asset Management. These hedge funds are supposed to deliver performance without the volatility that is indicative of long-only management and is part of why investors sign up in the first place.

Of course only time will tell how this year will end and next year will begin. While we are all on this ride called the equity markets, our investors rest assured that Clear will not stray from its mission or its disciplined investment strategy and risk management.

Fund of Funds... The Next Shoe to Drop?

Many in the press and the blogsphere have made the call that 20-50 more hedge funds will close due to subprime exposure or the recent volatility in the markets.

ETFs have basically performed with the market and sectors. Long-only managers have taken it on the chin, but again predominantly with their markets.

What I do not have a handle on and want to know who out there does, is how the hedge fund of funds have performed from June through this week?

The hammer that comes down on a single strategy hedge fund is obvious, they close. In the wake of the failure of Amaranth and its negative impact on several fund of funds; I am curious how the sultans of due diligence have handled these recent challenges?

Study Finds Exec Pay Strongly Linked to Performance

Back in November of 2006 a study by pension and HR consulting firm Watson Wyatt Worldwide, based on public data from 793 companies in the S&P Composite 1500 (our composite benchmark), found executives at financially high-performing companies are better compensated than their counterparts at underperforming companies, suggesting a strong link between pay and performance.

The study found that CEOs at higher-performing companies have significantly greater total compensation described as realizable pay, especially from long-term incentive (LTI) awards. Realizable pay calculates the current value of outstanding LTI awards granted over a specific time frame (the study was 2003-2005) using the ending stock price.

Between 2003 and 2005, the median realizable LTI for CEOs at higher-performing companies was $4.4 million, compared with $1.5 million at lower-performing companies. The study found similar results for realizable total pay, which includes stock incentives, cash compensation and annual bonuses, which tend to be less sensitive to shareholder returns.

Other study findings, according to a summary on the Watson Wyatt Worldwide Web site, included:

• Companies with greater executive stock ownership outperformed companies with lower ownership levels, further suggesting that pay opportunity has less of an impact than actual ownership.
• Companies that offer above-market LTI pay opportunities but have only medium-range stock price performance still deliver above-market pay. This is not a shareholder-friendly outcome. In contrast, companies that offer medium-range LTI opportunities deliver medium-range pay for medium performance and high pay only for high performance - a more shareholder-friendly outcome.
• Companies with greater five-year LTI opportunities underperformed companies with lower LTI opportunities.
• In 2005, organizations that kept a tight rein on option grants, as measured by run rates and accounting expense, outperformed their industry peers. The typical firm with low option run rates (less than 1% on average) in 2004 earned a shareholder return in 2005 that was more than 2.3 times as high as that of the typical firm with a high run rate.
• While companies have dramatically reduced their stock option run rates, they have seen only modest decreases in their overall dilution levels.
• The economic value of stock options at major US companies fell by 71% between 2001 and 2005, from a total of $137 billion to $40 billion. This is a clear response to shareholder concern over excessive dilution.

The conclusion may be that better pay equals better performance. The shareholder question is how much more pay does it take to achieve better performance, and how much pay is just too much? Where does well compensated end and egregious begin? Is there a company size issue at play? Are there retention and recruiting issues for underperforming and stagnant firms in need of acceleration?

In our opinion, aligning shareholder interests with executive pay seems to make the most sense. Basic compensation should be comfortable but not over the top. Stock options and bonuses should be on a pay for performance basis, as board approved milestones are passed. Annual compensation for grand performance can be grand, but as in our profession, come January 1, the meter goes back to zero and a new year should begin.

Our final thought on this is investability. Is this tracking successful enough to create an index or portfolio against it? Currently we do not find enough statistical significance to create a precise set of rules around compensation to index these findings. However, as we observe and record these trends we can incorporate them into our thought processes.

Mr. Corn is CEO of quantatative firms Clear Asset Management and Clear Indexes LLC.

Earning’s Season: Reported and Estimated

As a firm that lives by the mathematical algorithms that we use to select stocks, we are often asked about our opinion of earnings estimates. There are data providers that not only track the estimates of individual analysts, but also which analysts are the most accurate and which ones have “lost their crystal ball.” The data providers also track how often the public companies are really “managing” their earnings situation as to consistently beat the average consensus estimates. Public companies set and manage expectations by providing guidance in various forms to set the stage for where the firm may or may not be in terms of revenue or income within a future quarter.

More than 50% of all public companies provide earnings and other guidance to the street. Clear Asset Management and Clear Indexes use none of this type of information. Clear only analyzes data that is “posted and actual” by the public companies themselves.

Two laws preceded our opening our doors: Reg FD, for Fair Disclosure, came first. This law, at its essence, ensures that material information is disseminated to everyone simultaneously: Wall Street and Main Street. Previously, Wall Street analysts could receive non-public information by asking probing questions to management. This gave them, their traders and their clients a leg up on the rest of the world. Executives who have violated Reg FD have been placed in jail spawning whole service industries in investor relations, webcasting and numerous others, servicing public companies and their investment bankers to keep them in compliance and in the executive suite instead of the slammer.

The next law is the famous Sarbanes Oxley Act of 2002. At its core is the accuracy and consistency of reported data. We use the word “data” because it goes far beyond earnings and revenue numbers. It encompasses every financial number posted each quarter, all 6,800 of them (approximately), per company.

Clear Asset Management’s and subsequently Clear Indexes’ investment process utilizes a proprietary multifactor model to rank every public company and calculate a series of measures to compare companies by size, style, sector and others. We began our business with the outlook that the data landscape was being leveled and that the laws of the land were enacted to police the integrity of the data and its dissemination. Each year as historical data conforms to SarbOx rules our calculations are based on more consistent facts. So the date of our founding is not a coincidence, it is an intersection of investment process, advances in computer software and the cleansing and future quality of data. About a year ago today I posted for our clients the curve of financial restatements and other material signs of data integrity, showing that SarbOx is working.

Today, CFOs are seeing the hardship and consequences of providing guidance for earnings and explaining why their companies missed or exceeded previous forecasts. Analysts and many institutional investors as well as prop trading desks have come to expect these oracle-like predictions.

Some large cap firms have ceased to provide these reports and a trend may be at hand. Companies from mature industries that one may think are predictable like Coca-Cola, McDonald's, and Pfizer do not provide guidance. CFO Magizine recently ran a piece with some interesting statistics.

In fact, more than 60 percent of the 73 CFOs polled in a recent Financial Executives International survey said that they believe public companies should stop providing quarterly earnings guidance. Instead, that group favors providing a range of EPS predictions once a year.

The FEI survey was prompted by a recent U.S. Chamber of Commerce report that called for all U.S. public companies to stop giving quarterly forecasts. The Chamber hopes to incite "a stampede" of companies that will cease to issue EPS guidance, so the stoppage becomes widely acceptable, says David Hirschmann, a Chamber senior vice president. "Quarterly earnings guidance has outlived its usefulness."

The article quotes several CFOs who are afraid to stop the practice. They believe that if they stop, that Wall Street will interpret this as a sign of weakness and pound the stock.

Wake up public companies. We buy-siders, money managers and our institutional clients, want you focused on your business and not on micro-managing investor expectations. We want you to understand every facet of your business and focus on hitting appropriate internal milestones concerning revenue growth and operating efficiencies.

Every season is unpredictable until near the last day. We seek the companies that may surprise us and themselves on the upside. The mathematical analysis of actual data, balanced with their valuation compared to their peers holds the insights we seek. Checking on guidance every 90 days is not part of our investment process.

 

Stock Buybacks

There has been a lot of press and subsequent comment in the blogsphere concerning the unprecedented amount of stock buybacks, meaning companies buying their own stock.

To give you an idea of the magnitude of stock buybacks, S& P issued a statement last quarter that companies in the S&P 500 index bought back $110 billion in stock during the third quarter of 2006 which is up 35% from a year ago. It was the twelfth consecutive quarter of greater than 20% growth in buybacks for the index, and just below the record $117 billion in buybacks conducted in the second quarter.

The perceived impact on the market is what is causing all the clamor, but before we get to the 2006 version of this, I want to share what we were thinking five and ten years ago. Back in those days, many buy backs were considered poor management. Translated: if management could not develop strong enough projects to increase revenue and profit growth organically (projects that require funding) than the next best thing to do with the cash would be a strategic acquisition or perhaps a special dividend. The only real use of buybacks back then was to have enough shares on hand to dish out to managers, senior and otherwise. There were of course exceptions.

Today the issues are somewhat different. The main stream media appears to assume that investors, even sophisticated ones, may not understand the formula which is profit divided by the number of shares equals earnings per share (EPS). If the number of shares is reduced via buybacks and earnings remain constant then EPS goes up, which is rather obvious to those of us who can handle third grade math. The press calls this a material impact on earnings affecting over 20% of the S&P 500. They basically think that investors are so dumb that this simple equation is not understood or investors are not paying enough attention to the issues. Appearances are that earnings are accelerating faster because of buybacks.

Who are these seemingly devious big companies buying their shares back Q406? The big sectors are Information technology 25%, energy firms 15% and financial companies 12%. They disclose the buy backs, the stock options issued and analysts; buy and sell side, calculate the costs, benefits and synthetic changes to earnings per share.

As quantitative investment managers we have made no adjustments to our algorithms for the buybacks. Why?

The arithmetic is simple. We screen and rank other measures beyond EPS such as: Net Income, Cash Flow and Debt. If a company scores higher with its EPS with no debt, higher net income and increased cash flow, this is a scenario where the buyback may have been excellent use of firm capital. If the buyback was financed with debt, or hurt cash flow we score that appropriately.

To those of us used to looking at ALL the numbers, objectively and in a highly disciplined process, we do not consider the buyback talk worthy to be labeled shenanigans. We view each buyback as one facet of the overall picture of a firm. We then compare all of our scores for that firm with that of its peers and all of the companies in its investment style to assign it a ranking that may or may not qualify it for inclusion in one of our portfolios.

Managing Expectations During Turbulent Times

I want to share a client communication I posted 3/2 in the wake of yesterday’s sell off. As I stated this morning on Bloomberg radio, there are always cracks in the data to be found. The glass can be half full or empty. We are in volatile times and we may see a direction for the market for 2007 in the coming months. I suggest that you look at May 2006 or April and October 2005. Those who winced lost, those who focused won. Times are different, but some investing principals remain the same.

Market Moves – originally published for Clear’s clients on 3/2/07

If one observes the market in snapshots it is highly volatile and cyclical. Looking at S&P 500 index returns as a long-term trend line, an obvious pattern appears. The market trends up over time, however rarely in a straight line.

The market events of this week may have shaken the media but not the investment industry. The downturn makes for excellent gloom and doom headlines which is great for selling ads on the web, TV and newspapers. After all, that is the business of media. As holders of Google (GOOG) in the Clear Large Cap Growth portfolio and CBS (CBS) as a constituent in the Clear Spin-Off Index, we appreciate their business models. Being long-term investors, we take these market movements seriously and with the knowledge and experience that we have seen this before. As long-term investors, we have a plan of what to do.

Being in the market for the long haul has its benefits. A recent study published by Citigroup clearly demonstrates how the wealthiest people gain significantly more wealth by participating in the capital markets; in other words, they own stocks and gain the long-term benefits of the markets. It also illustrates how they stick to their asset allocation plans when the market pulls back. The rest of the global population does not have the resources to invest and thus loses the best opportunity to earn money outside of a rising career. This is sometimes referred to as: the rich get richer.

Looking at the S&P chart is quite compelling.

The S&P 500 was launched on March 4, 1957 (Happy Anniversary) and as of yesterday the S&P 500 has closed up 6,608 days, with an average daily gain of 2.71 points (0.63%). It has closed down on 5,900 days, with an average loss of 2.80 points (-0.64%). For those doing the math of total days in their head while reading, yes there were 73 days where there was no change in the index.

The strongest year for returns for the S&P 500 was 1958 when it rose 38.06%. Its worst was 1974, when it lost 29.72%.

Reflecting on the challenging week that ended today, we look at other short term moves. March 14, 2000, the index fell 83.95 points and was followed on March 16, 2000, when it rose 66.33 points. Another example is the infamous October 19, 1987 market drop of 20.47% which was followed by October 21, 1987, the best one day gain for the index of 9.10%.

So looking back to the Clear portfolios, as we do every day, we are calculating which stocks have the highest probability to beat their benchmarks and only purchasing on behalf of our investors the absolute top ranked stocks. Let the markets continue their long term trend, now 50 years old.

Everyone Counts

The media loves to write about how individual investors do not move the market. When workers are counting the dollars saved for retirement and pool them with their peers and everyone who works and saves through 401 (k) plans, the numbers are significant. The stats we are quoting today are from the Hewitt 401(k) index and they beg to differ with the media portrayal. This data was pointed out earlier this week by Plan Sponsor, which publishes a daily newsletter. The Hewitt 401(k) index tracks the inflows and outflows of money in company retirement plans and what types of funds they are going into and out of. This provides us some insights on how individual investors influence the overall market.

The S&P 500 rose 1.51%, including dividends, in January. New money being put to work is a potential ingredient for the rise. Please note, the day the money moves to funds is not correlated to the day it is invested. The mutual fund industry is not like managed separate accounts at Clear Asset Management and moves at its own particular speed.

Participants in 401 (k) plans reversed a trend that favored fixed-income in 2006. In January 2007, fund transfers weighed heavily towards equities on 60% of the trading days and in volume.

The biggest days were right after long weekends. Specifically, January 3 and January 16 were the largest for changes in the direction of inflows; add three more peak days in the month, and this essentially showed investor confidence by moving more money into equities. In 2006 there was an average of only two peak days per month perhaps indicating less interest in changing investment strategies. Keep in mind that most plan participants typically do not reallocate their assets. If they do, it is most often at the end of a quarter. The fact that this inertia was overcome to reallocate assets toward equities shows investor confidence in equities.

International funds received the largest inflows, gaining over 25% of incoming transfers followed by Large Cap US equity at 22%, and lifestyle/asset allocation funds at just over 20%. These very simple lifestyle funds gained $135 million for the month, another trend.

Workers saving for retirement are beginning to diversify their holdings. We applaud the media for bringing so much attention to the benefits of diversification, with 62.52% or just over $407 million of the outflows coming from company stock. Further demonstrations of investor confidence in equities is measured by the amount of outflows that came from GIC/Stable value offerings, which totaled just over $201 million, which were the bulk of the rest of outflows.

Despite those trends, participant contributions, which are based on individual predetermined asset allocation, continued to flow to large US equity funds 22.6%, GIC/Stable Value at nearly 16%, and lifestyle funds with just over 15%. International funds, which garner more press attention, drew only about 11% of monthly contributions.

Company stock, despite investors fleeing in January, continued to draw 9% of the contribution inflow directed by participants and, not surprisingly, more than 27% of total contributions when including employer-directed money.

Education about asset allocation and diversification is still crucial to working people achieving their investment goals.

From our perch, we see this flow into equities and away from low yielding investments and concentrations of company stock as adding more long term reward to the nest egg of participants, reducing their risk of not meeting investment goals. Simultaneously, the inflow of cash to the capital markets benefits the global economy.

Come out of the Closet!

It seems that active managers rarely beat the benchmark according to Paul Lim at the NY Times who wrote an article this past Sunday highlighting the seemingly statistical futility of active management. The question is: is it really futile or are too many managers being called active when they are really closet indexers? First let’s look at the stats from the article.

This year through September, only 28.5 percent of actively managed large-capitalization funds — which try to beat the market through stock selection — were able to outpace the S.& P. 500 index of large-cap stocks, according to a new study by S.& P. In the third quarter alone, it was even worse, with only one in five actively managed large-capitalization funds beating the index.

Over the five years through the end of the third quarter — a span that included both bull and bear markets — only 29.1 percent of large-cap funds managed to beat the S.& P. 500. What’s more, only 16.4 percent of mid-cap funds beat the S.&P. 400 index of mid-cap stocks, and 19.5 percent of small-cap funds outpaced the S.& P. 600 index of small-company shares.

We believe there are several influencers to these statistics.

1)      Beta-phobia. Managers are afraid of beta. Managers are afraid of deviating from the benchmark too much, especially in a down market even if they enjoy beta in an up market.

2)      Too many names. Portfolios need capacity to scale. To this end, most managers tend to select hundreds of names (stocks) for their portfolios.

3)      No concentration. To further minimize risk, many managers, with too many names, mimic the sector weighting of their benchmark.

4)      Stock selection by committee. If that bright young analyst is being head hunted and they are truly smart, sooner or later their ideas need to make it into the portfolio or you will risk losing them. The question is would the manager have selected the stock.

5)      Emotion. Screwed by an airline, in love with a new gadget, packed stores or your significant other loves their products. These are not platforms for investment decisions.

6)      Fees. You can’t beat an index by mimicking it. Even the largest index funds have fees, so by definition these funds cannot beat the benchmark.

As active quantitative managers, we say the above list, although not too unusual makes for milquetoast management and increases the odds for negative selection.

There are many great active managers out there beating the indexes and doing the real job they set out to do.

My perspective:

1) Beta is welcomed as long as alpha exceeds it. It is not to be feared.

2 & 3) The closer the number of stocks in a portfolio is to the number in the benchmark, the harder to beat that benchmark. Sector bets and stock selection in concentrated portfolios are the foundation of active management.

4) The team approach works in certain situation, just not this one. Checks and balances, risk controls, and multiple perspectives all have their role to play. Ultimately there is a style and investment process in place for a reason. Discipline regardless of headlines and short-term trends is what ultimately wins.

5) In most professions, the human element is usually a good thing, but not when it comes to managing portfolios. Emotion, intuition and personal experience are usually counter productive.

6) Active manager’s fees are higher; they certainly should be, when earned.

My conclusion is to distinguish real active management versus closet indexing. That good managers design their investment process and stick with it. They design what they want to be, the processes to get there and take the measured risks to achieve their goal – long-term out-performance.

We choose algorithmic based stock selection and rules based trading. Calculating sector weightings based on millions of comparisons and then selecting the winners from the pack (median players and losers). It is all quantitative, and it is what we trained for, designed and are paid to do. The difference between us and other managers isn’t guts. It is almost the opposite. It is sticking to their mandate and investment process, their roots, and not pretending to be active. Come out of the closet of indexing that is, and once again be: active managers.

That’s what we are talking about.